Suppose that there are two countries in the world, USA and Australia, and that each country consumes a tradable good with international price PT = P ∗ T = 2. Assume also that each country consumes local transportantion, a non-tradable service, where the price for nontradables in USA is PN = 1 and in Australia it is P ∗ N =2. Suppose that the law of one 2 price holds for tradable goods and assume that the pricing index φ(P1, P2) = P1^0.5 *P2^0.5, which satisfies the properties discussed in class. (i) Assume that the law of one price holds. What is the value of the nominal exchange rate? (ii) Express the real exchange rate e as a function of relative prices of non-tradables to tradables in Australia and USA, and calculate its value. (iii) How would a tax to local transportation in Australia affect the real exchange rate? (iv) Use the Balassa-Samuelson theory discussed in class to express the real exchange rate in terms of relative productivities of tradable and non-tradable sectors in USA and Australia. (v) What are the effects of a technological progress in the Australian tradable sector on the real exchange rate? (vi) Suppose that the US Government would like to revert the real exchange rate to its level before the technological progress in the Australian tradable sector. How can the government use taxes on either sector to revert the movements in exchange rates? Use math to justify your answer.
Suppose that there are two countries in the world, USA and Australia, and that each country consumes a tradable good with international
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